Valuation

Valuation for Mergers and Acquisitions

Introduction

Valuation of the enterprises, a comprehensive exercise, is the most critical part of any M&A
due to the depth of analysis required and number of aspects to be looked into. From the basic
understanding of the enterprise a suitable method has to be decided. Sometimes due to the
peculiar business model of the industry or the enterprise the valuer may have to device a
suitable valuation model or modify the existing ones. Here we discuss the different methods of
valuation and the use of a particular method for as particular restructuring mode and particular
industry.
Normally Chartered Accountants or a category I Merchant Bankers are appointed to work out
the value of shares of companies involved in the merger and based on the values so computed
the exchange ratio is worked out.

General characteristics of valuation

Meaning
An enterprise is accumulation of assets and liabilities which is an outcome of some investment
and commercial activities. So valuation of an enterprise means the value to that investment at
given point of time. It is also characterised by forward-looking approach, which is again based
on the knowledge, experience and judgment of the valuer. The valuation may done one or
more of the three dimensions i.e. going concern or liquidity or market value.
General characteristics

• It is more of an art than science : Valuation requires a lot of creativity, ingenuinity and
subjectivity.
• Subjectivity concept : Valuation is subjective and hence no two valuers can arrive at the
same decision as their own perceptions of future may vary.
• Relative concept : Valuation for merger is a relative value and not an absolute value.
Thus similar assumptions and methods should be used to get values of transferee and
transferor company on same level and thus work out exchange ratios.
• Quantitative and qualitative aspects : Not only assets and profitabilty but other qualitative
and quantitative factors have to be taken into consideration.

Factors affecting valuation

There are certain basic factors which affect the value of a company's share. The valuation
based on similar assumptions and methods would be different due to the factors affecting
valuation. Some of the factors are listed below

• The nature of company's business

• The caliber of managerial personnel
• Prospects of expansion
• Financial structure of the company
• The legal implications
• The incidence of direct and indirect taxes
• Government policy in general and in relation to particular industry
• Future maintainable profit
 • Current market price of shares

It should be noted that as the number of factors affecting valuation is endless and varies from
case to case, it is not possible to list all of them.

Valuation of Shares

I. Profitability Based Methods

Valuation of shares may be classified as valuation for quoted shares and valuation for
unquoted shares. In order to decide the exchange ratio the most important part is the
valuation of shares.
The profitability based valuation can be further classified into

A. Yield method
B. Future maintainable profit method
C. Discounted cash flow method
D. Profit Earning Capacity Value method

The approach to valuation of shares on this basis would need determination of two
factors viz

 Average future maintainable profit and

 Rate of capitalization

E. Yield method

This method considers dividend as the base for valuation of shares. Future
maintainable profit is estimated and the same is capitalised by a predetermined rate
of capitalisation. This method is not very popular and is used very rarely. It is used
only in case of small shareholdings.
Computation

 Work out the average dividend per share.

 Estimate future dividend for the estimated period say three to five years.
 Work out weighted average for the estimated future dividend.
 Estimate the rate of capitalisation
 The weighted average dividend is capitalised based on the dividend yield
rate of the shares of listed companies.

F. Future maintainable Profit Method

The working under this method includes valuation on the basis of pre-determined
earnings based on future earnings. Usually future maintainable profit method is
used for going concern companies. This method is highly popular and is often used.
While working out the value under the earnings based method future projections are
considered but it may not be possible to work out reasonably accurate future
projections, so finally majority of the valuations are worked out based on past profits
by taking clue from the projections for future growth.
 Computation

 Estimate future maintainable profits after adjusting for any extra-ordinary

or non-recurring items.
 Decide on the rate of capitalisation of profits
 Capitalise the future maintainable profits
 Divide the capitalised profits by the number of equity shares to arrive at
the value per share

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G. Discounted Cash Flow Method

This method is based on time value of money and is suitable when future cash
flows are uneven and inconsistent. This is the most popular method and is used
often. The discounted cash flow technique uses the expected free cash flows from
the business for determining the value of business. The value of business is equal
to the sum of the present value of various future cash flows to the business.
Computation

 Determine the number of years for which the future cashflow can be
worked out on reasonable assumptions.
 Determine the end values of the business.
 Determine the discounting rates.
 Determine the future cash flows.
 Add the residual value of the business at the end of the period of work to
the discounted value.
 From the value arrived at above, deduct the amount of loans, if any.
 Divide the value at above by the total no. of shares to arrive at the value
of per share.

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H. Profit Earning Capacity Value Method

The valuation under this method is based on the capacity of the company to earn
profits in the future. Under this method the valuation is done on the basis of past
trends and future expected profitability of the company. Unusual profits in the near
past are ignored.
Computation

 The value is calculated after considering the past trends and expected
trends in profits of the company.
 The average profits before tax for the last three years are computed on
the basis of simple or weighted average.
 Provision for tax and preference dividend are deducted therefrom.
 The profits arrived are divided by number of shares to compute the
earnings per share.
 The Profit Earning Capacity Value is calculated as : EPS / Capitalization
rate.
 Mostly inverse of P/E ratio is used as the capitalization rate .
 I. Valuation based on Market Value

This method is based on the value of shares in the existing market. The value for
which the assets are available in the open market is considered for its valuation.
This method is used for companies or firms acquired on a going concern but this
method is not so popular and is not frequently used.
The value of unquoted and unlisted shares is arrived at after discounting the value
arrived for quoted and listed shares. The discounting rate depends upon the liquidity
factor, current profitability, management policies, asset holding etc.

J. Asset based Methods

Valuation on assets of an unlisted and an unquoted company is done on a different

footing as compared to listed and quoted company.This method is used generally
when profit trends cannot be established or when the company is under liquidation.
Under this method the valuation is arrived at on the basis of the assets available
with the company. The total assets of the company as reduced by the total liabilities
is called the net asset value of the company. It represents the true net worth of the
business after providing for all the outside, present and potential liabilities. It is
generally used when the business is acquired as a going concern.
Computation

Total Assets xxx

(-)Total Liabilities xxx

Net Assets
xxx.
or Net Worth

OR

Share capital
xxx
(equity capital)

Free Reserves xxx

(-) Contingent Liabilities xxx.

Net assets
xxx.
or Net Worth

Net Asset Value per share = Net Worth / Number of shares including fresh and
bonus shares

Valuation of Assets

Some companies may prefer to acquire / takeover or merge only the assets of the target
company to avoid the burden of liabilities of the target company. The assets can be
valued under three methods viz

I. Market Value Method

II. Book Value Method
III. Replacement Method

I. Market Value

The value for which the assets are available in the open market is considered for its
valuation. This method is used when the business is considered as a going concern.
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II. Book value

The assets acquired are acquired at the value in which they appear in the books. This
method is generally used when the target company is under liquidation.
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III. Replacement Value

The total cost of replacing the assets to be acquired is computed considering the
following aspects

o Gestation period
o Basic infrastructure cost
o Cost of transport
o Cost of installation
o Cost of finance to purchase the assets, if any

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Conclusion

Valuation is not a mere calculation of figures and numbers but it is a lot more than that.
The final valuation under any one method for two different companies is bound to vary as
valuation is a subjective concept and also the assumptions and future projections vary
from company to company and valuer to valuer.

Consideration

The consideration is given to the transferor company or to its shareholders. The discharge of
purchase consideration has to be planned carefully as the financial and tax implications of
each mode of discharge are different. Hence, the consideration to be given in the transaction
of M&As is an issue of strategic consideration
The consideration can be in the form of

• Shares
Equity shares (with and without voting rights)
Preference shares
• Debentures
• Cash
• Distribution of assets of Transferee Company
• Takeover of liabilities of Transferor company
If the consideration is paid in such a manner that shareholders holding 90% of the
shares in the transferor company become the shareholders of the transferee company,
then the requirements of all the Indian laws and Accounting Standards are satisfied.

Costs involved
Proper structuring of a merger transaction can lead to substantial savings in costs like stamp
duty, income tax etc. The various costs that have to be incurred to complete a merger are :

• Administrative expenses

Expenses relating to holding the Extraordinary General Meeting including printing &
posting of notices
Advertisement Expenses
Individual notices for hearing of petition - printing & posting

• Legal Expenses

Filing fees
Drafting the schemes of amalgamation
Auditors' Expenses
Advocates fees

• Duties and taxes

Stamp Duty
Income tax for the Transferor Company and its shareholders

• Loss of concessions

Income tax deuctions, concessions etc.

Sales tax benefits
Excise duty concessions such as SSI Exemptions, CENVAT etc.